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19 April 2017

Brexit: Recent Developments and Potential Repercussions

Following its formal notification to the EU of its intention to withdraw from the union, the UK will soon enter into negotiations with the bloc over an exit agreement. Early indications are that the exit negotiations will be a difficult and uncharted process. While Brexit has not caused noticeable damage to the British economy so far, the opening of divorce talks will inevitably lead to a prolonged period of uncertainty, thereby creating a significant drag on the UK's economic performance.

One of the most immediately apparent consequences of the Brexit vote has been the decision of Theresa May, the British Prime Minister, to call for a surprise general election on 8 June 2017, ostensibly a measure designed to smooth the passage of the required Brexit legislation through Parliament by expanding the majority of the ruling Conservative Party. Given the widely assumed positive outcome of the election, however, it is unlikely that the UK economy will be adversely affected by uncertainty in the brief period leading up to the ballot.

The ultimate British departure, in all likelihood, will pose something of a threat to the global economy, including Hong Kong. Although the negative impacts may take time to unfold, as Britain will remain in the EU for the time being, a weakened UK economy, aggravated by an anaemic sterling, is likely to result over time in a weaker appetite among British consumers and businesses for imports into the UK. In addition, Brexit may erode the UK’s dominant position as an investment destination as the country becomes less attractive as a gateway to the EU. On the other hand, Hong Kong does have an opportunity to play a bigger role in helping UK companies get established in Asia to tap business opportunities beyond the EU.

The Brexit Process

The UK voted to sever its 44-year EU membership in a historic referendum held on 23 June 2016. Overall, 51.9% of voters opted to leave the EU, against 48.1% who voted to stay. While many of the English regions and Wales strongly supported Brexit, the majority of voters in London, Scotland and Northern Ireland backed maintaining the status quo.

After securing permission from the UK Parliament, Theresa May finally triggered Article 50 of the Lisbon Treaty on 29 March 2017, formally notifying the EU of the UK’s decision to quit the EU. The EU then released its draft negotiating guidelines on 31 March 2017. These guidelines, which are expected to be approved by the remaining 27 member states on 29 April 2017, lay out the broad directions in which the EU expects talks with the UK to proceed.

The withdrawal talks between the EU and the UK are likely to commence as early as June 2017. Under Article 50, two years are allowed to complete the talks, starting from the date it was triggered. If negotiations remain unfinished by then, the two-year period can be extended by unanimous agreement of the other member states. But if no extension is agreed, the UK will automatically cease to be part of the EU by 29 March 2019.

All EU laws will remain applicable in the UK until the exit agreement comes into force or the negotiation period expires. The UK remains an EU member during this period, and is obliged to continue to carry out all EU duties and obligations; but it will be barred from participating in the discussion and decision of new EU policies.

The UK’s Plan for a Post-Brexit Partnership with the EU

The UK has made it clear that in the upcoming negotiations it will not pursue a partial or associate membership of the EU, or any other model that leaves it “half-in, half-out”. Pursuing a clean break from the EU, the plan is for the UK to leave the European Single Market and the EU’s customs union, removing the UK from the jurisdiction of the European Court of Justice (ECJ), ending the country’s contributions to the EU’s budget, and taking back control of immigration by halting the free movement of EU citizens into the UK.

This plan shows it is the UK’s intention to avoid replicating other models of partial EU membership which had previously been floated as potential prototypes for a post-Brexit relationship with the EU. Most notable among these are the Norwegian model, encompassing membership of the European Economic Area (EEA) and the European Free Trade Association (EFTA), and the Swiss model, with EFTA membership and a myriad of bilateral agreements with the EU enabling free access to the single market across a number of different sectors. As far as trade is concerned, the UK will not seek to adopt a model already enjoyed by other countries.

Comprehensive Free Trade Agreement

As an alternative to such models, the UK will seek the greatest possible access to the EU market through a new, comprehensive and fully reciprocal free trade agreement (FTA). Such an agreement would afford businesses on both sides the maximum freedom to trade with – and operate within – each other’s markets. The agreement may try to tie in elements of the Single Market in certain specified economic sectors such as financial services. However, such cherry-picking will be difficult, if not impossible, as the EU has already ruled out a sector-by-sector approach to the participation in the Single Market.

The UK hopes to reach an agreement on its future relationship with the EU by the time that the two-year Article 50 process has ended. Yet the EU has opted for a phased approach, with the priority given to talks on the terms of divorce rather than negotiations on the future trade relationship. To further complicate this issue, trade deals with the EU often take many years to conclude. Finding compromise among all member states, all with their own diverse interests in the agreement, may prove challenging.

A New Type of Customs Relationship

The UK has stated its intention to remain outside the customs union after its withdrawal from the EU, given its desire to begin preparing trade agreements with other partners immediately, while still complying with its EU obligations. The UK government is considering a number of options for a new customs arrangement with the EU, such as drawing up a completely new agreement, or remaining a signatory to some of the elements of the existing customs union.

In essence, the EU customs union is a trade agreement that allows goods that have entered any country in the union to move freely to any other member country without tariffs, border checks, rules of origin and customs formalities. All members of the customs union are bound by the EU’s Common Commercial Policy and the Common External Tariff, restraints which prevent members from freely negotiating their own trade deals with other countries.

As an alternative to membership of the customs union, the UK is envisioning some sort of customs agreement with the EU which would make cross-border trade tariff-free and as frictionless as possible. Such an agreement would likely require the UK and the EU to agree to adhere to the same product regulations on traded goods, and potentially require the UK to harmonise its legislation with that of the EU in certain areas, including consumer protection, competition law and intellectual property.

A Role for WTO Rules

The UK is currently a member of the World Trade Organisation (WTO), though like the 27 other EU member states, its relationship with the organisation is for the most part governed by the EU. After the UK has withdrawn from the EU, it will have to renegotiate its WTO terms of membership, including the maximum tariff levels that the UK can impose on imports from other WTO members. It is expected that the UK will try to adopt the EU’s schedules for tariffs in the short term, while in the longer term availing itself of its newfound liberty to fix its own schedules.

If the UK and the EU cannot reach a trade agreement, their trading relationship will be governed by WTO laws. Under this option, the UK would be free to impose import tariffs on goods entering the country, both from the EU and elsewhere. On the other hand, the EU would be obliged to impose its Common External Tariff on UK imports. Tariffs could be imposed every time goods crossed the EU-UK border, suggesting that the UK would not have any preferential treatment when accessing the single market.

In all likelihood, it will be an uphill battle for the UK to strike a favourable trade deal with the EU. Reaction to the UK’s plan for the talks with the EU suggests that the UK might have overestimated its negotiating leverage. It has been pointed out that the UK needs trade with the EU more than vice versa – while about 47% of UK exports go to the EU, only 7% of EU exports head to the UK.

Likely Consequences for the UK

The referendum result sent immediate shockwaves across the UK financial market, of which the main features were a plunge in stock prices and sharp depreciation of sterling. Yet such volatility proved to be short-lived. While sterling has remained weak, the stock market has since resumed its upward trajectory, although the financial market has fluctuated widely again following Theresa May’s decision to call for a snap election.

So far at least, Brexit has not brought about noticeable damage to the British economy. Indeed, the sharp decline in the value of sterling since the vote has not only bolstered UK exports, but also attracted a significant number of overseas visitors, resulting in a mini-boom in the trading and tourism sectors. Unemployment, which had been falling for several years, has continued to decline and interest rates, which some commentators had initially expected to rise this year, have been kept at historically low levels in the wake of the Brexit vote.

However, there are growing signs that consumers are becoming more cautious as the anaemic pound pushes up inflation, while the looming exit negotiations are tending to make businesses wary about long-term investment. Britain raised its official growth forecast for 2017 from 1.4% in November 2016 to 2% in March 2017, but lowered the figures for 2018 and 2019 from 1.7% and 2.1% to 1.6% and 1.7% respectively.

The commencement of divorce talks will certainly lead to a prolonged period of uncertainty, one that will weigh heavily on the country's economic performance. Nearly half of all British exports go to the EU, and exporting businesses may hold back investment until they can see the terms on which the UK will be trading with Europe. The heightened uncertainty over the new arrangements between Britain and the EU is further expected to discourage investment inflows as foreign companies may prefer investing in other EU countries, as an alternative to the UK, in order to guarantee free access to the single market.

With this in mind, the British government has called for an immediate start of talks on the future free trade relationship with the EU, while also making preparations to forge new deals with third countries as soon as it is allowed. At a time when trade is increasingly negotiated on a regional or bloc-to-bloc basis, the British government would have to begin negotiations from scratch with a host of countries and trading blocs. Compared to the EU, which has a huge market and substantial political clout, the UK on its own will have a greatly reduced bargaining power when conducting these negotiations.

To complicate matters further, there is a possibility that the UK will lose so-called “passporting” rights for its financial services industry. These currently allow the UK’s banks and financial institutions to operate anywhere in the EU. If this right was given up, it would threaten the dominant position of the City of London, and encourage financial services firms to transfer to other parts of the EU – particularly locations within the Eurozone, such as Frankfurt and Paris. HSBC, for example, is likely to transfer about 1,000 jobs from London to Paris; Goldman Sachs has announced plans to move the bulk of its EU-based jobs to Frankfurt; while Morgan Stanley is expected to shift some employees from the UK to a number of other EU member states.

Even more seriously, failure to conclude an exit agreement will have devastating social, political, financial and economic consequences. As noted, the absence of an exit agreement would lead to a reversion to WTO rules. As well as facing higher import tariffs when exporting to the EU, UK firms may also face more complex technical barriers and customs formalities. Moreover, the need to re-create a customs border between Northern Ireland (which remains part of the UK) and the Irish Republic (an EU member state) is likely to lead to intense political problems for the UK. The possibility of such a customs border returning has already encouraged calls for a referendum in Northern Ireland on Irish reunification. Coupled with the growing pressure for a new independence referendum in Scotland in response to Brexit, the British government is already having to deal with the possibility (albeit still a remote one) of an eventual break-up of the UK.

Likely Implications for the EU

The British departure from the EU will pose serious threats, not only to the UK, but also the world economy at large. At present, the UK is the world’s 5th largest economy (with a 4% share of global GDP) and the EU’s second largest (it comprises 16% of EU GDP). It is also the world’s 5th largest trader (with 3% of global trade) and the EU’s 2nd largest (with 10% of EU trade). Brexit is likely to hurt the EU by disrupting its well-established economic and trade relations with the UK. Although less than 10% of EU exports are destined for the UK, Britain imports more from most EU member states than it exports to them. The UK is therefore a valuable market for export-oriented states like Germany that enjoy trade surpluses with the UK.

In the course of exit negotiations, sustained pressure on the pound is expected to remain a drag on the euro, thereby aggravating Europe’s ongoing global currency instability. Early indications are that the negotiations will be an arduous and uncharted process, with the EU likely to delay talks on any trade deal until sufficient progress is made on the terms of an orderly withdrawal. That will include a settlement of the UK’s “exit bill” (that is, how much Britain must pay to meet its current and future obligations to the EU – a sum currently estimated to be as much as 60 billion euros) as well as a resolution of the border issue in Northern Ireland, and the status of Gibraltar. Growing uncertainty over the negotiations will only lead to increased financial market volatility, which may cause further harm to the global economic and trade environment.

For the EU as a whole, the loss of the UK, a leading financial centre and one of the few comparatively fast-expanding economies in Europe, will definitely have negative repercussions on EU growth. The bloc would further suffer from the absence of an influential supporter of trade and service liberalisation. At member state level, those with stronger trade, investment and financial links to the UK, such as the Irish Republic and the Netherlands, are likely to be most affected.

However, a number of EU member states may benefit somewhat from the British departure. Germany and France, the two largest economies in the EU, are poised to absorb any diversion of trade and investment from the UK. Frankfurt and Paris are emerging as the favourites to win banking and finance business lost by the City of London. Even the Irish Republic and the Netherlands may be able to take advantage of the UK’s withdrawal. Ireland will be attractive to companies that have previously invested in the UK, given its similar legal system, while the Netherlands can boast of its excellent transport links.

On the political front, the UK’s departure has provided a boost to populist and Eurosceptic political parties across the EU. Although it is still proving difficult for such anti-establishment parties to gain power in the short term, the rise in their popularity is likely to encouraging governing parties in some EU states to take a more nationalistic stance, and perhaps even spur some of them to push for their own referendums on EU membership. Even if no member states ultimately choose to leave, any intensified anti-EU sentiment will hinder the further integration and development of the bloc, which may translate into a less lucrative market for the rest of the world.

Expected Impacts on Hong Kong

Although the impact of Brexit will be less significant in Asia, the uncertainty associated with establishing a new relationship between the UK and the EU could still be detrimental to Hong Kong businesses trading with and investing in the UK. The UK was Hong Kong’s 3rd largest market in the EU in 2016, with imports from Hong Kong worth HK$50bn (some 15% of total exports from Hong Kong to the EU), and the 12th largest in the world (accounting for 1.4% of Hong Kong’s total global exports). About 56% of Hong Kong exports to the UK were consumer goods, such as electronics, clothing, jewellery, toys and timepieces, with capital goods making up a 37% share.

However, as the UK is likely to remain in the EU at least until 29 March 2019, Hong Kong’s relation with Britain should largely be business as usual for the time being. But while the UK will continue to adopt the EU’s trade policy until the exact exit terms are in place, increasing regulatory divergence over the longer term may add to the cost of exporting to the country. More importantly, a fragile UK economy, along with a soft pound, will weaken the demand for imports.

In terms of investment, the UK is now the largest recipient of foreign direct investment (FDI) in the EU, but Brexit may erode the UK’s dominant position as an investment destination. The UK is likely to become less attractive as a gateway to the EU, as a base for business regional headquarters, and as a location for investment from the EU.

Against this backdrop, it is expected that, in the wake of Brexit, some Hong Kong companies may consider shifting part of their investment in the UK to other EU countries. The UK receives far more of Hong Kong’s outward direct investment than any other EU member country (HK$249bn in 2015, 65% of the total amount invested in the EU), and with 2.1% of the total invested globally, more than all but three other countries in the world.

On the other hand, Brexit is expected to galvanise more UK companies into looking beyond the EU to capture new business opportunities and new markets in Asia. Being the business hub in the region, Hong Kong, with its close historical, cultural and trade links with the UK, can play an important role in helping UK companies get established in Asia in general, and in China in particular.

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